Inflation/Deflation
Highlights Duration: The upturn in bond yields is not yet confirmed by our preferred global growth indicators. We anticipate that a reduction in trade uncertainty during the next few months will cause our indicators to rebound. But until then, investors should view the bond sell-off as tenuous. Yield Curve: Expect modest 2/10 steepening during the next few months, as the Fed keeps rates low even as economic growth improves. Steepening will show up in real yields, not in the TIPS breakeven inflation curve. The 2/10 slope will stay in a range between 0 bps and 50 bps for the next 6-12 months. Yield Curve Strategy: The 5-year Treasury note looks expensive compared to the rest of the yield curve, and historical correlations suggest it will rise the most if the Fed delivers fewer rate cuts than are currently expected. We recommend that investors short the 5-year bullet versus a duration-matched 2/30 barbell. Await Confirmation Bond yields look like they might be bottoming. The 2-year and 10-year Treasury yields are up 10 bps and 31 bps, respectively, since the 2/10 slope briefly inverted in late August (Chart 1). We are cautiously optimistic that the growth revival getting priced into Treasury yields will materialize. However, it’s vital to note that the yield rebound is not yet confirmed by the economic data. Even timely global growth indicators like the CRB Raw Industrials index remain downbeat (Chart 1, bottom panel). If global growth measures don’t bottom soon, then Treasury yields are certain to fall back. Chart 1Yields Are Ahead Of The Data We do expect the economic data to follow bond yields higher. We noted in last week’s report that the weakness in US economic data is concentrated in survey measures (aka “soft” data), while measures of actual economic activity (aka “hard data”) are holding up well.1 For example: The ISM Manufacturing survey is below its 2016 trough, but the year-over-year growth rate in industrial production is well above 2016 levels (Chart 2, top panel). Capacity utilization also remains elevated (Chart 2, bottom panel). New orders for core capital goods are holding firm, even with CEO confidence at its lowest since 2009 (Chart 2, panel 2). Employment growth remains strong, despite the employment component of the ISM Non-Manufacturing survey being just above the 50 boom/bust line (Chart 2, panel 3). Chart 2Will "Soft" Data Rebound? Our interpretation of the divergence is that uncertainty about the US/China trade war is weighing on sentiment and holding survey measures down. If that uncertainty is removed, survey measures will quickly rebound and converge with the “hard” data. On that front, we think it’s very likely that trade uncertainty diminishes during the next few months. The US and China have already agreed to an informal “phase one deal” that will require China to buy $40-$50 billion of US agricultural goods while the US delays the October 15 tariff hike. Odds are that President Trump will also delay the planned December 15 tariff hike and probably roll back some existing tariffs.2 The reason is that while Trump’s overall approval rating has been consistently low; until recently, he had been receiving high marks for his handling of the economy (Chart 3). But his economic approval rating took a tumble this summer and, as we head toward the 2020 election, he desperately needs an economic boost and/or policy victory to push up his numbers. We already see some tentative signs of a rebound in the regional Fed manufacturing surveys. A tactical retreat on trade should improve sentiment and cause survey data to move higher, alongside bond yields. And in fact, we already see some tentative signs of a rebound in the regional Fed manufacturing surveys (Chart 4). October figures are out for the New York, Philadelphia, Richmond, Kansas City and Dallas surveys, and they have all diverged positively from the national ISM. Chart 3It's Trump's Economy Chart 4Some Optimism From Regional Surveys Bottom Line: The upturn in bond yields is not yet confirmed by our preferred global growth indicators. We anticipate that a reduction in trade uncertainty during the next few months will cause our indicators to rebound. But until then, investors should view the bond sell-off as tenuous. Yield Curve: Macro Drivers We noted in the first section that the 2/10 Treasury slope has steepened sharply since it briefly broke below zero in late August. In this section, we consider whether this 2/10 steepening might continue. To do this we run through the main macro drivers of the yield curve. The Fed Funds Rate Traditionally, there is a very tight correlation between the fed funds rate and the slope of the curve (Chart 5). Fed tightening puts upward pressure on the curve’s front-end relative to the back-end, leading to a bear-flattening. Conversely, Fed easing drags the front-end down relative to the long-end, leading to bull-steepening. Chart 5The Fed's Yield Curve Control The traditional pattern broke down between 2009 and 2015 when the fed funds rate was pinned at zero. This period saw many episodes of bear-steepening and bull-flattening. But since the funds rate has been off zero, the traditional correlation has begun to re-assert itself. Our base case outlook calls for one more 25 bps rate cut tomorrow, followed by an extended on-hold period. This scenario might be expected to impart some mild steepening pressure to the curve, except for the fact that the front-end is already priced for 53 bps of easing during the next 12 months, significantly more than we expect. Our base case outlook calls for one more 25 bps rate cut tomorrow, followed by an extended on-hold period. If our base case scenario is incorrect, and growth continues to deteriorate, forcing the Fed to cut rates all the way back to zero. Then we would expect some initial bull-steepening, followed by bull-flattening as the funds rate approaches the zero bound. Wage Growth Wage growth is another excellent yield curve indicator, mainly because it helps determine the direction of the fed funds rate. Stronger wage growth causes the Fed to tighten and the curve to flatten. On the flipside, wage growth is a less effective indicator during Fed easing cycles, when it tends to lag changes in the funds rate (Chart 6). In fact, while wage growth is tightly correlated with the 2/10 slope, it lags changes in the slope by about 12 months (Chart 6, panel 2). Chart 6Wages Lead Tightening, But Lag Easing The upshot is that if the economy heads toward recession, then wage growth will not be a timely indicator of Fed rate cuts. However, if recession is avoided and wages continue to accelerate (Chart 6, bottom 2 panels), strong wage growth will limit how accommodative the Fed can be as it seeks to re-anchor inflation expectations. As such, persistently strong wage growth will limit the amount of curve steepening that can occur. Inflation Expectations The Fed’s need to re-anchor inflation expectations in a range consistent with its target is the main reason to forecast curve steepening. At present, the 10-year TIPS breakeven inflation rate is a mere 1.66%, well below the 2.3%-2.5% range that the Fed would consider “well anchored”. One might conclude that if the Fed succeeds in driving this rate higher, it will impart significant steepening pressure to the curve. However, we must also note that the 2-year TIPS breakeven inflation rate is even lower than the 10-year rate (Chart 7). Given our view that long-dated inflation expectations adapt only slowly to the actual inflation data, we would expect both the 2-year and 10-year breakevens to rise in tandem, exerting some modest flattening pressure on the curve.3 Chart 7Any Steepening Will Come From Real Yields Ironically, if the Fed is successful in re-anchoring long-dated inflation expectations, we expect it will cause the yield curve to steepen, but through its impact on real yields. At present, the 2-year and 10-year real yields are 0.37% and 0.14%, respectively. The act of holding rates steady for long enough to re-anchor inflation expectations will exert downward pressure on the 2-year real yield, while the 10-year real yield will rise in response to an improved growth outlook. The Fed’s goal of re-anchoring inflation expectations will likely lead to some curve steepening, but through the real component of yields, not the inflation component. The Neutral Rate The neutral rate – the fed funds rate that is neither inflationary nor deflationary – is a major wild card when it comes to the yield curve. Right now, the median Fed estimate calls for a neutral rate of 2.5%, while the market is pricing-in an even lower rate of 2%, at least according to the 5-year/5-year forward Treasury yield (Chart 8). Neutral rate estimates have been revised lower during the past few years, exerting significant flattening pressure on the yield curve. In theory, if we reach an inflection point where neutral rate estimates are revised higher, it would lead to substantial curve steepening. One thing to watch to help predict movement in neutral rate estimates is the gold price.4 Gold performs well when the market perceives monetary policy as increasingly accommodative, either because the Fed is cutting rates or because the assumed neutral rate is rising. The 2013 drop in gold foreshadowed downward revisions to the Fed’s neutral rate estimate (Chart 8, bottom panel). A further increase in gold, especially once the Fed stops cutting rates, would send a strong signal that current neutral rate estimates are too low. Monetary policy arguably exerts its greatest economic impact through the housing market. Investors can also watch the housing market for clues about the neutral rate. Monetary policy arguably exerts its greatest economic impact through the housing market. If housing activity starts to wane, it can be a strong signal that interest rates are too high. Last year, housing activity started to flag once the mortgage rate moved above 4% (Chart 9). If 4% proves to be the ceiling on mortgage rates, it would mean that the Fed’s current neutral rate estimate is roughly correct. However, home prices have moderated since last year, and new construction has started to focus more on the low-end of the market, where supply remains scarce.5 This shift in focus from homebuilders has caused the price of new homes to fall considerably (Chart 9, bottom panel), a supply side re-adjustment that could make the housing market more resilient in the face of higher rates. Chart 8Tracking The Neutral Rate: Gold Chart 9Tracking The Neutral Rate: Housing An upward re-assessment of the neutral rate would impart steepening pressure to the yield curve, but only if it occurs quickly, before the Fed has time to deliver offsetting rate hikes. However, we think it’s more likely that any increase in neutral rate estimates will occur gradually, alongside Fed tightening. In that case, a roughly parallel upward shift in the yield curve would be the most likely outcome. Verdict Considering all of the above factors, we would look for some modest 2/10 curve steepening during the next few months. The steepening will be driven by the Fed’s desire to re-anchor long-dated inflation expectations, a desire that will result in them keeping rates steady (apart from one more cut tomorrow), even as economic growth improves. As noted above, this steepening will show up in real yields, not in the TIPS breakeven inflation curve. That being said, strong wage growth and overly dovish market rate cut expectations will ensure that any steepening is well contained. We expect the 2/10 slope to stay in a range between 0 bps and 50 bps for the next 6-12 months. Yield Curve Strategy Chart 10Treasury Yield Curve When thinking about how to position a Treasury portfolio for our expected yield curve outcome, we first look at the value proposition offered by different Treasury maturities. Chart 10 shows the Treasury yield curve, and also each maturity’s 12-month rolling yield. The rolling yield is simply the combination of each maturity’s 12-month yield income and the price impact of rolling down the curve. It can be thought of as the return you would earn holding each bond for 12 months in an unchanged yield curve environment. The first thing that sticks out in Chart 10 is that the 5-year note offers poor value. We also note that the curve steepens sharply beyond the 5-year maturity point, so maturities greater than 5 years benefit a lot from rolldown. The simple intuition from Chart 10 is confirmed by our butterfly spread models.6 Chart 11shows that the 5-year bullet looks very expensive relative to a duration-matched barbell portfolio consisting of the 2-year and 10-year notes. In fact, with only a few exceptions, bullets are expensive relative to barbells across the entire Treasury curve (see Appendix). Chart 11Bullets Are Very Expensive All else equal, bullets tend to outperform barbells when the yield curve steepens. However, given current valuations, it would take a lot of steepening for bullets to outperform barbells during the next few months. Chart 12Yield Curve Correlations Further, Chart 12 shows that the front-end of the yield curve – out to about the 5-year/7-year point – tends to steepen when our 12-month discounter rises, while the long-end of the curve – beyond the 7-year point – tends to flatten. Given that our 12-month discounter is currently -53 bps, meaning that the market is priced for 53 bps of rate cuts during the next year, we expect it will rise during the next few months. This should exert the most upward pressure on the 5-year/7-year part of the curve. We have been recommending that investors play the curve by going long a 2/30 barbell and shorting the 7-year bullet. But given the significant rolldown advantage in the 7-year compared to the 5-year, we amend that recommendation this week. We now recommend that investors short the 5-year bullet and go long a duration-matched barbell consisting of the 2-year and 30-year maturities. Bottom Line: The 5-year Treasury note looks expensive compared to the rest of the yield curve, and historical correlations suggest it will rise the most if the Fed delivers fewer rate cuts than are currently expected. We recommend that investors short the 5-year bullet versus a duration-matched 2/30 barbell. Appendix Table 1Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of October 25, 2019) Table 2Butterfly Strategy Valuation: Standardized Residuals (As of October 25, 2019) Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 2 For further details on BCA’s outlook for US/China trade negotiations please see Geopolitical Strategy Weekly Report, “How Much To Buy An American President?”, dated October 25, 2019, available at gps.bcaresearch.com 3 For further details on how inflation expectations adapt to the actual inflation data please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Signal From Gold?”, dated May 1, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 6 For details on our butterfly spread models please see U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Geopolitical risks are starting to abate as a result of material constraints influencing policymakers. China needs to ensure its economy bottoms and a debt-deflationary tendency does not take hold. President Trump needs to avoid further economic deterioration arising from the trade war. The U.K. is looking to prevent a recession induced by leaving the EU without an agreement. Iran and the risk of an oil price shock is the outstanding geopolitical tail risk. Feature Readers of BCA’s Geopolitical Strategy know that what defines our research is our analytical framework – specifically the theory of constraints. Chart 1The Electoral College – An Overlooked Constraint The theory holds that policymakers are trapped by the pressures of their office, their nation’s global position, and the stream of events. These pressures emerge from the material world that we inhabit and as such are measurable. If a leader lacks popular approval, cannot command a majority in the legislature, rides atop a sinking economy, or suffers under stronger or smarter foreign enemies, then his policy preferences will be compromised. He will have to change his preferences to accommodate the constraints, rather than the other way around. Case in point is the U.S. electoral college: it proved an insurmountable political constraint on the Democratic Party in 2016. The college is intended to restrain direct democracy or popular passions; it also restrains the concentration of regional power. In 2012, Barack Obama won a larger share of the electoral college than the popular vote, while in 2016 Hillary Clinton won a smaller share (Chart 1). Clinton’s lack of appeal in the industrial Midwest turned the college and deprived her of the prize. The rest is history. In this report we highlight five key constraints that will shape the direction of the major geopolitical risks in the fourth quarter. We recommend investors remain tactically cautious on risk assets, although we have not yet extended this recommendation to the cyclical, 12-month time frame. China’s Policy: The Debt-Deflation Constraint We have a solid record of pessimism regarding Chinese President Xi Jinping’s willingness and ability to stimulate the economy – but even we were surprised by his tenacity this year. His administration’s effort to contain leverage, while still stimulating the economy, has prevented a quick rebound in the global manufacturing cycle. The constraint limiting this approach is the need to avoid a debt-deflation spiral. This is a condition in which households and firms become pessimistic about the future and cut back their spending and borrowing. The general price level falls and drives up real debt burdens, which motivates further cutbacks. A classic example is Japan, which saw a property bubble burst, destroying corporate balance sheets and forcing the country into a long phase of paying down debt amid falling prices. China has not seen its property bubble burst yet. Prices have continued to rise despite the recent pause in the non-financial debt build-up (Chart 2). Looser monetary and fiscal policy have sustained this precarious balance. But the result is a tug-of-war between the government and the private sector. If the government miscalculates, and the asset bubble bursts, then it will be extremely difficult for the government to change the mindset of households and companies bent on paying down debt. It will be too late to avoid the vicious spiral that Japan experienced – with the critical proviso that Chinese people are less wealthy than the Japanese in 1990 and the country’s political system is less flexible. A Japan-sized economic problem would lead to a China-sized political problem. This is why the recent drop in Chinese producer prices below zero is a worrisome sign (Chart 3). Policymakers have loosened monetary and fiscal policy incrementally since July 2018 and they are signaling that they will continue to do so. This is particularly likely in an environment in which trade tensions are reduced but remain fundamentally unresolved – which is our base case. Chart 2China's Property Bubble Intact Chart 3China's Constraint Is Debt-Deflation Are policymakers aware of this constraint? Absolutely. If the trade talks collapse, or the global economy slumps regardless, then China will have to stimulate more aggressively. Xi Jinping is not truly a Chairman Mao, willing to impose extreme austerity. He oversaw the 2015-16 stimulus and would do it again if he came face to face with the debt-deflation constraint. Is China still capable of stimulating? High debt levels, the reassertion of centralized state power, and the trade war have all rendered traditional stimulus levers less effective by dampening animal spirits. Yet policymakers are visibly “riding the brake,” so they can remove restraints and increase reflation if necessary. Most obviously, authorities can inject larger fiscal stimulus. They have insisted that they will prevent easy monetary and credit policies from feeding into property prices – and this could change. They could also pick up the pace when it comes to reducing average bank lending rates for small and medium-sized businesses.1 In short, stimulus is less effective, but the government is also preferring to save dry powder. This preference will be thrown by the wayside if it hits the critical constraint. The implication is that Chinese stimulus will continue to pick up over a cyclical, 12-month horizon. There is impetus to reduce trade tensions with the U.S., discussed below, but a lack of final resolution will ensure that policy tightening is not called for. Bottom Line: China’s chief economic constraint is a debt-deflation trap. This would engender long-term economic difficulties that would eventually translate into political difficulties for Communist Party rule. If a trade deal is reached, it is unlikely alone to require a shift to tighter policy. If the trade talks collapse, stimulus will overshoot to the upside. Trade War: The Electoral Constraint The U.S. and China are holding the thirteenth round of trade negotiations this week after a summer replete with punitive measures, threats, and failed restarts. Tensions spiked just ahead of the talks, as expected. Immediately thereafter President Trump declared he will meet with Chinese negotiators to give a boost to the process and reassure the markets.2 Trump’s major constraint in waging the trade war is economic, not political. Americans are generally sympathetic to his pressure campaign against China. Public opinion polls show that a strong majority believes it is necessary to confront China even though the bulk of the economic pain will be borne by consumers themselves (Chart 4). Yet Americans could lose faith in Trump’s approach once the economic pain fully materializes. Critically, the decline in wage growth that is occurring as a result of the global and manufacturing slowdown is concentrated in the states that are most likely to swing the 2020 election, e.g. the “purple” or battleground states (Chart 5). Chart 4Americans To Confront China Despite The Costs? Chart 5Trump Faces Pressure To Stage A Tactical Trade Retreat Furthermore, a rise in unemployment, which is implied by the recent decline in the University of Michigan’s survey of consumer confidence regarding the purchase of large household goods, would devastate voters’ willingness to give Trump’s tariff strategy the benefit of the doubt (Chart 6). Wisconsin and Pennsylvania, two critical states, have seen a net loss of manufacturing jobs on the year. The fear of an uptick in U.S. unemployment will prevent Trump from escalating the trade war. An uptick in unemployment would be a major constraint on Trump’s trade war – he cannot escalate further until the economy has stabilized. And that may very well require tariff rollback while trade talks “make progress.” We expect that Trump is willing to do this in the interest of staying in power. As highlighted above, the Xi administration is not without its own constraints. Our proxies for China’s marginal propensity to consume show that Chinese animal spirits are still vulnerable, particularly on the household side, which has not responded to stimulus thus far (Chart 7). Since this constraint is less immediate than Trump’s election date, Xi cannot be expected to capitulate to Trump’s biggest demands. Hence a ceasefire or détente is more likely than a full bilateral trade agreement. Chart 6Waning Consumer Confidence On Big Ticket Items Foreshadows Rise In Unemployment Trump’s electoral constraint also suggests that he needs to remove trade risks such as car tariffs on Europe and Japan (which we expect he will do). We have been optimistic on the passage of the USMCA trade deal but impeachment puts this forecast in jeopardy. Chart 7China's Trade War Constraint? Animal Spirits Bottom Line: Trump will stage a tactical retreat on trade in order to soften the negative impact on the economy and reduce the chances of a recession prior to the November 3, 2020 election. China’s economic constraints are less immediate and it is unlikely to make major structural concessions. Hence we expect a ceasefire that temporarily reduces tensions and boosts sentiment rather than a bilateral trade agreement that initiates a fundamental deepening of U.S.-China economic engagement. U.S. Policy: The Economic Constraint The 2020 U.S. election is a critical political risk both because of the volatility it will engender and because of what we see as a 45% chance that it will lead to a change in the ruling party governing the world’s largest economy. Will Trump be the candidate? Yes. If Trump’s approval among Republicans breaks beneath the lows plumbed during the Charlottesville incident in 2017 (Chart 8A), then Trump has an impeachment problem, but otherwise he is safe from removal. Judging by the Republican-leaning pollster Rasmussen, which should reflect the party’s mood, Trump’s approval rating has not broken beneath its floor and may already be bouncing back from the initial hit of the impeachment inquiry (Chart 8B). The rise in support for impeachment and removal in opinion polls is notable, but it is also along party lines and will fade if the Democrats are seen as dragging on the process or trying to circumvent an election that is just around the corner. Chart 8ARepublican Opinion Precludes Trump’s Removal Chart 8BRepublican-Leaning Pollster Shows Support Holding Thus Far How will all of this bear on the 2020 election? Turnout will be high so everything depends on which side will be more passionate. A critical factor will be the Democratic nominee. Former Vice President Joe Biden, the establishment pick, has broken beneath his floor in the polling. His rambling debate performances have reinforced the narrative that he is too old, while the impeachment of Trump will fuel counteraccusations of corruption that will detract from Biden’s greatest asset: his electability. According to a Harvard-Harris poll from late September, 61% of voters believe it was inappropriate for Biden to withhold aid from Ukraine to encourage the firing of a Ukrainian prosecutor even when the polling question makes no mention of any connection with Biden’s son’s business interest there. Moreover, 77% believe it is inappropriate that Biden’s son Hunter traveled with his father to China while soliciting investments there. With Vermont Senator Bernie Sanders’s candidacy now defunct as a result of his heart attack and old age, Elizabeth Warren, the progressive senator from Massachusetts, will become the indisputable front runner (which she is not yet). In the fourth primary debate on October 15, she will face attacks from all sides reflecting this new status. Given her debate performances thus far, she will sustain the heightened scrutiny and come out stronger. This is not to say that Warren is already the Democratic candidate. Biden is still polling like a traditional Democratic primary front runner (Chart 9), while Warren has some clear weaknesses in electability, as reflected in her smaller lead over Trump in head-to-head polls in swing states. Nevertheless Warren is likely to become the front runner. Chart 9Biden Polling About Average Relative To Previous Democratic Primary Front Runners The recession call remains the U.S. election call. Two further considerations: Impeachment and removal of President Trump ensure a Democratic victory. There are hopes in some quarters that President Trump could be impeached and removed and yet his Vice President Mike Pence could go on to win the 2020 election, preserving the pro-business policy status quo. The problem with this logic is that Trump cannot be removed unless Republican opinion shifts. This will require an earthquake as a result of some wrongdoing by Trump. Such an earthquake will blacken Pence’s and the GOP’s name and render them toxic in the general election. Not to mention that Pence’s only act as president in the brief interim would likely be to pardon Trump and his accomplices. He would suffer Gerald Ford’s fate in 1976. Which means that a significant slide in Trump’s approval among Republicans will translate to higher odds of a Democratic win in 2020 and hence higher taxes and regulation, i.e. a hit to corporate earnings expectations. We expect this approval to hold up, but the market can sell off anyway because … The market is overrating the Senate as a check on Warren in the event she wins the White House. It is true that relative to Biden, Warren is less likely to carry the Senate. Democrats need to retain their Senate seat in Alabama, while capturing Maine, Colorado, and Arizona (or Georgia) in addition to the White House in order to control the Senate. Biden is more competitive in Arizona and Georgia than Warren. But this is a flimsy basis to feel reassured that a Warren presidency will be constrained. In fact, it is very difficult to unseat a sitting president. If the Democrats can muster enough votes to kick out an incumbent and elect an outspoken left-wing progressive from the northeast, they most likely will have mustered enough votes to take the Senate as well. For instance, unemployment could be rising or Trump’s risky foreign policy could have backfired. Chart 10Business Sentiment Threatens Trump Re-Election In our estimation the Democrats have about a 45% chance of winning the presidency, and Warren does not significantly reduce this chance. The resilient U.S. economy is Trump’s base case for success. But Trump’s trade policy and the global slowdown are rapidly eating away at the prospect that voters see improvement (Chart 10). This speaks to the constraint driving a ceasefire with China above, but it also speaks to the broader probability of policy continuity in the U.S. As Warren’s path to the White House widens, there is a clear basis for equities to sell off in the near term. Bottom Line: Trump’s approval among Republicans is a constraint on his removal via impeachment. But the status of the economy is the greater constraint. The recession call remains the election call. While we expect downside in the near term, we are still constructive on U.S. equities on a cyclical basis. War With Iran: The Oil Price Constraint The Senate will remain President Trump’s bulwark amid impeachment, notwithstanding the controversial news that Trump is moving forward with the withdrawal of troops from Syria, specifically from the so-called “safe zone” agreed with Turkey, giving Ankara license to stage a larger military offensive in Syria. This abandonment of the U.S.’s Kurdish allies at the behest of Turkey (which is a NATO ally but has been at odds with Washington) has provoked flak from Republican senators. However, it is well supported in U.S. public opinion (Chart 11). Trump is threatening to impose economic sanctions on Turkey if it engages in ethnic cleansing. The Turkish lira is the marginal loser, Trump’s approval rating is the marginal winner. The withdrawal sends a signal to the world that the U.S. is continuing to deleverage from the Middle East – a corollary with the return of focus on Asia Pacific. While the Iranians are key beneficiaries of this pivot, the Trump administration is maintaining maximum sanctions pressure on the Iranians. The firing of hawkish National Security Adviser John Bolton did not lead to a détente, as President Rouhani has too much to risk from negotiating with Trump. Instead the Iranians smelled U.S. weakness and went on the attack in Saudi Arabia, briefly shuttering 6 million barrels of oil per day. The response to the attack – from both Saudi Arabia and the U.S. – revealed an extreme aversion to military conflict and escalation. Instead the U.S. has tightened its sanctions regime – China is reportedly withdrawing from its interest in the South Pars natural gas project, a potentially serious blow to Iran, which had been hyping its strategic partnership with China. This reinforces the prospect for a U.S.-China ceasefire even as it redoubles the economic pressure on Iran. As long as the U.S. maintains the crippling sanctions on Iran, there is no guarantee that Tehran will not strike out again in an effort to weaken President Trump’s resolve. The fact that about 18% of global oil supply flows through the critical chokepoint of the Strait of Hormuz is Iran’s ace in the hole (Chart 12). It is the chief constraint on Trump’s foreign policy, as greater oil supply disruptions could shock the U.S. economy ahead of the election. Trump can benefit from minor or ephemeral disruptions but he is likely to get into trouble if a serious shock weakens the economy at this juncture. Chart 11U.S. Opinion Constrains Foreign Policy Chart 12Oil Price Constrains U.S. Policy Toward Iran An oil shock does not have to originate in Hormuz shipping or sneak attacks on regional oil infrastructure. Iran is uniquely capable of fomenting the anti-government protests that have erupted in southern Iraq. The restoration of stability in Iraq has resulted in around 2 million barrels of oil per day coming onto international markets (Chart 13). If this process is reversed through political instability or sabotage, it will rapidly push up against global spare oil capacity and exert an upward pressure on oil prices that would come at an awkward time for a global economy experiencing a manufacturing recession (Chart 14). Chart 13Iran's Leverage Over Iraq Chart 14Global Oil Spare Capacity Constrains Response To Crisis Bottom Line: Iran’s power over regional oil production is the biggest constraint on Trump’s foreign policy in the region, yet Trump is apparently tightening rather than easing the sanctions regime. The failure of the Abqaiq attack to generate a lasting impact on oil prices amid weak global demand suggests that Iran could feel emboldened. The U.S. preference to withdraw from Middle Eastern conflicts could also encourage Iran, while the tightening of the sanctions regime could make it desperate. An oil shock emanating from the conflict with Iran is still a significant risk to the global bull market. Brexit: The No-Deal Constraint The fifth and final constraint to discuss in this report pertains to the U.K. and Brexit. We do not consider the October 31 deadline a no-deal exit risk. Parliament will prevail over a prime minister who lacks a majority. Nevertheless the expected election can revive no-deal risk, especially if Boris Johnson is returned to power with a weak minority government. Chart 15U.K.: Public Opinion Constrains Parliament And No-Deal Brexit While parliament is the constraint on the prime minister, the public is the constraint on parliament. From this point of view, support for Brexit has weakened and the Conservative Party is less popular than in the lead up to the 2015 and 2017 general elections. The public is aware that no-deal exit is likely to cause significant economic pain and that is why a majority rejects no-deal, as opposed to a soft Brexit. Unless the Tory rally in opinion polling produces another coalition with the Northern Irish, albeit with Boris Johnson at the helm, these points make it likely that a no-deal Brexit will become untenable when all is said and done (Chart 15). If Johnson achieves a single party majority the EU will be more likely to grant concessions enabling him to get a withdrawal deal over the line. We remain long GBP-USD but will turn sellers at the $1.30 mark. Investment Implications The path of least resistance is for China’s stimulus efforts to increase – incrementally if trade tensions are contained, and sharply if not. This should help put a floor beneath growth, but the Q1 timing of this floor means that global risk assets face additional downside in the near term. We continue to recommend going long our “China Play” index. U.S.-China trade tensions should decline as President Trump looks to prevent higher unemployment ahead of his election. China has reason to follow through on small concessions to encourage Trump’s tactical trade retreat, but it does not face pressure to make new structural concessions. We expect a ceasefire – with some tariff rollback likely – but not a big bang agreement that removes all tariffs or deepens the overall bilateral economic engagement. Stay long our “China Play” index. We remain short CNY-USD on a strategic basis but recognize that a ceasefire presents a short term (maximum 12-month) risk to this view, so clients with a shorter-term horizon should close that trade. We are long European equities relative to Chinese equities as a result of the view that China will stimulate but that a trade ceasefire will leave lingering uncertainties over Chinese corporates. U.S. politics are highly unpredictable but constraint-based analysis indicates that while the House may impeach, the Senate will not remove. This, combined with Warren’s likely ascent to the head of the pack in the Democratic primary race, means that Trump remains favored to win reelection, albeit with low conviction (55% chance) due to a weak general approval rating and economic risks. The risk to U.S. equities is immediate, but should dissipate. The U.S. is rotating its strategic focus from the Middle East to Asia Pacific, which entails a continued rotation of geopolitical risk. However, recent developments reinforce our argument in July that Iranian geopolitical risk is frontloaded relative to the China risk. This is true as long as Trump maintains crippling sanctions. Iran may be emboldened by its successes so far and has various mechanisms – including Iraqi instability – by which it can threaten oil supply to pressure Trump. This is a tail risk, but it does support our position of being long EM energy producers. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Please see BCA Research, China Investment Strategy Weekly Report, “Mild Deflation Means Timid Easing,” October 9, 2019, available at cis.bcaresearch.com. 2 China knows that Trump wants to seal a deal prior to November 2020 to aid his reelection campaign, while Trump needs to try to convince China that he does not care about election, the stock market, or anything other than structural concessions from China. Hence the U.S. blacklisted several artificial intelligence companies and sanctioned Chinese officials in advance of the talks. The U.S. opened a new front in the conflict by invoking China’s human rights abuses in Xinjiang, which is also an implicit warning not to create a humanitarian incident in Hong Kong where protests continue to rage. These are pressure tactics but have not yet derailed the attempt to seal a deal in Q4.
Highlights The Chinese economy is still slowing, and there is not yet enough evidence from forward-looking economic data to suggest a turnaround is imminent. Deflation has returned to China’s industrial sector. Even though overall price deceleration has been relatively mild, it is further squeezing already deteriorating industrial profit growth. We do not expect deflation to spiral into a 2015/2016-style episode, which removes at least one risk to our growth outlook. At the same time, a mild deceleration in prices will not provide enough incentive for Chinese policymakers to hit the stimulus button. The People’s Bank of China’s new interest rate-setting regime, the LPR, will not provide much in the way of stimulus over the next few months. But it has the potential to improve China’s monetary policy transmission mechanism over the coming year, increasing the odds that policymakers will succeed in stabilizing economic activity. Short-term downside risks to growth have not abated, and we remain tactically bearish on Chinese stocks. Cyclically, we continue to recommend an overweight stance, on the basis of an eventual reacceleration in economic activity. Feature Chart 1The Chinese Economy Is Still Slowing China’s economy is at a critical juncture: “Half-measured” stimulus so far has been able to keep the domestic economy in better shape than in the 2015-2016 down cycle, but overall economic activity has not bottomed (Chart 1). The Sino-America trade talk has resumed at the moment, but the two sides have yet to make any substantive progress towards a deal. In the meantime, the global economy has also reached a critical point where the degree of economic weakness has the potential to feed on itself, possibly triggering a recession.1 This underscores our tactically bearish stance towards Chinese stocks versus the global equity benchmark. Barring more forceful stimulus or resolution on the trade front, any external shock and/or internal policy missteps could easily tip the Chinese economy into a deeper growth slowdown. Hence, downside risks remain elevated for Chinese stocks over the next 3- to 6-months. The “D” Word Returns, But Won’t Spur Aggressive Further Easing Chart 2Industrial Price Deflation Returns Economic data over the past two months have provided mixed signals. Readings from both China’s National Bureau of Statistics (NBS) PMI and from the Caixin PMI show an improvement in the manufacturing sector. However, industrial deflation has returned to China: Three years after the country declared victory against a prolonged industrial destocking cycle, producer price inflation (PPI) relapsed into negative territory in July and declined further in August (Chart 2). While prices are typically lagging indicators and reflect lingering effects from past economic conditions, there is not enough evidence in forward-looking economic data right now to suggest a turnaround in the economy is imminent.2 A deflationary PPI is not a trivial source of concern for Chinese policymakers. Last time growth in China’s PPI turned negative, it took policymakers four and a half years and an annualized 28% of GDP worth of credit expansion to pull the industrial sector out of its deflationary cycle. Chart 3Deflation Threatens Recovery In Industrial Profit Growth For investors, deflation has pernicious effects on profits, and we have received several client inquiries concerning the topic since PPI growth turned negative. The historical relationship suggests profit growth for both the A-share and investable markets is highly linked to fluctuations in producer prices (Chart 3), and China’s industrial sector profit growth has already been rapidly deteriorating over the past 12 months. The good news is that we do not expect the current episode of PPI deflation to become as protracted as it did in 2012-2016, or as severe as in 2015-2016. Two reasons underpin our view: Since early-2018, monetary policy has been much easier than during past deflationary episodes. Monetary policy in the past year and half has been much more accommodative than in the three years leading to the deep industrial deflationary cycle in 2015, particularly on the exchange rate front. The RMB was soft-pegged to a rising U.S. dollar before it was decoupled by the PBoC in August 2015, and was appreciating against its trading partners throughout most of 2012-2015. Bank lending rates were also kept at historically high levels during this period (Chart 4). This time, even though money and credit growth has not returned to the same pace as in 2015-2016, current ultra-loose monetary conditions should spur enough credit growth to keep prices from deflating aggressively. Chart 4Monetary Conditions Easier Than Last Cycle Inventory levels are low, and capacity levels do not appear to be overly excessive. After years of industrial consolidation, China’s industrial capacity does not appear to be particularly excessive compared to the past cycle. This is distinctively different from the prolonged contraction in PPI between 2012 and 2016, when China’s industrial inventories were coming off a five-year-long destocking cycle, and capacity utilization fell markedly (Chart 5). This is not the case today. Moreover, even though final demand has been weak, production has retrenched even more, drawing down inventories to the point where the pace of inventory destocking may have reached a cyclical bottom (Chart 6). A re-stocking of industrial goods should boost producers’ pricing power. Chart 5Capacity Is Not Excessively Underutilized Chart 6Inventory Destocking May Be Bottoming Out But the bad news (for investors), is that contained, or mild producer price deflation will not be reason alone to spur aggressive further easing from policymakers. This means that the re-emergence of price deflation, even mild and short-lived, will weigh on earnings and investor sentiment. Bottom Line: This episode of producer price deflation is unlikely to become as pernicious as occurred in the past, but policymakers are thus unlikely to act aggressively to counter it. While this removes some of the downside risks for Chinese stocks, even mild deflation will weigh on earnings growth (and thus sentiment) which underscores our tactically bearish stance on Chinese stocks. Demystifying China’s New Loan Prime Rate: Not The Stimulus You Are Looking For On August 20th, the PBoC launched a new loan prime rate (LPR) system, a revamped reference regime for setting bank loan interest rates3 (Chart 7). In September, the new LPR rate for one-year bank loans was lowered by five basis points. Since then, the market has been fixated on predicting whether the PBoC will cut the Medium-Lending Facility (MLF) rate next, which would be perceived as a change in China’s monetary stance. Chart 7China's New LPR: A Shadow 'Tax Cut' PBoC will increase its control of the pricing of credit, while tight financial regulations will restrict the size and speed of credit growth. The new LPR reform, in our view, is designed to force state-owned (and better-capitalized) commercial banks to hand out a “tax cut” to struggling small- and medium-sized enterprises (SMEs) by lowering bank lending rates. At the same time, it allows the PBoC to take back control of the pricing of credit from commercial banks, “killing two birds with one stone.” There are three main market implications from this approach: The new LPR is likely to gradually narrow the gap between corporate bond yields (i.e. “market rates”) and bank lending rates; A cut in the MLF rate in the near term should be interpreted as a “reward” to commercial banks rather than a stimulus for the economy; Most importantly, the new LPR system does not mean rapid credit expansion is in the cards. Quite the opposite, in the near term, banks may tighten their lending. The wide spread between the 3-month interbank repo rate and average bank lending rate illustrates the reason why the PBoC has introduced the LPR.4 This gap is also evident when comparing the yield of AAA-rated corporate bonds and the average bank lending rate (Chart 8). These gaps exist because Chinese commercial banks have largely manipulated the 1-year bank lending rate set by the PBoC when lending to their “preferred customers,” usually state-owned enterprises and real estate developers, by offering significantly discounted loan rates. Banks then charge substantial “risk premiums” on loans to the private sector, mostly SMEs, to make up for the narrower profit margins on loans to SOEs (Chart 9). Chart 8An Impaired Monetary Policy Transmission Mechanism Chart 9Evidence Of Asymmetrical Lending Practices The new LPR system is designed to minimize this discrepancy, since the new LPRs are more market based and are quoted based on the price of loans banks charge their prime clients. By design, the new LPR system should force the average bank lending rate closer to the rate companies borrow in the bond market. This means bank lending rates will be guided lower, including lending rates for SMEs. However, the new system will be implemented in phases, and the PBoC is likely to gradually guide LPRs lower to allow banks to readjust their pricing models. The LPR rate is essentially the MLF rate plus bank profit margins (the added basis points above the MLF rate). The market will guide the top line lending rate, while the PBoC will have control over the floor rate (MLF) through open market operations. The fact that the PBoC is keeping the MLF rate unchanged while allowing the LPR to drop (albeit slightly) sends an explicit message: The PBoC is forcing banks to lower lending rates first before boosting their now-narrowed profit margins by lowering the MLF rate. In contrast to expectations of market participants that the LPR system will ease credit conditions, banks may actually tighten their lending in the coming months. While the PBoC will increase its control of the pricing of bank loans by the rate reform plan, the strengthening in financial regulations that has occurred over the past year will restrict the size and speed of credit growth. This combination has created more room for monetary easing without unleashing “animal spirits.” Borrowing costs to risky institutions have been higher since the Baoshang Bank takeover and are likely to remain elevated even if interest rates are lower (Chart 10). More importantly, mortgage and real estate developer loans together account for nearly 30% of total bank credit. Unless policymakers ease the brakes on lending restrictions to the property sector, bank lending growth is unlikely to pick up meaningfully (Chart 11). In fact, the PBoC has explicitly excluded mortgage and property-related lending from benefitting from the LPR rate cut.5 Barring a significant worsening in economic data, we do not expect the PBoC to lower mortgage lending and real estate-related loan rates in the coming months. Chart 10Tightened Financial Regulations Will Keep Cost Of Risky Lending High Chart 11Mortgage Rate Unlikely To Return To Its 2016 Low Finally, in the next two- to three-quarter mandatory implementation period, banks will be readjusting their pricing and credit risk-assessing models. During the transition, we expect more cautious sentiment among both lenders and borrowers. Hence, in the short term, bank loan growth may actually moderate. Bottom Line: The new LPR system may lower China’s banking sector profits in the short term. But in the next 6- to 12-months, we expect the PBoC to compensate commercial banks by keeping ample liquidity in the interbank system and by eventually lowering the MLF rate. The new LPR system may slow bank credit growth in the next few months, but after its full implementation (by the second quarter of 2020), it will have the potential to make PBoC’s policy more effective. Investment Conclusions We expect two phases of Chinese equity relative performance over the coming year: one phase of flat-to-potentially seriously down performance to last from now until sometime in the first quarter of 2020 when the economy bottoms, and then a phase of outperformance. Our expectation that the economy will bottom in Q1 2020 rests on the existing reflationary response by Chinese policymakers and an improved monetary transmission mechanism. Chart 12We Expect The Chinese Economy To Bottom In Q1 2020 Our expectation that the economy will bottom in the first quarter of 2020 continues to rest on the existing reflationary response by Chinese policymakers (Chart 12), and the fact that China’s new LPR system has the potential to improve what is currently a seriously impaired monetary transmission mechanism beyond the next two or three quarters. But the existing response of policymakers has been considerably more measured when compared to past economic cycles, meaning that equity investors are unlikely to be as forward-looking as they otherwise might be. Weak producer price deflation will weigh on investor sentiment, and it is unlikely to be weak enough to spur aggressive further easing. The potential for further escalation of the U.S.-China trade war also compellingly argues against an overweight stance in the near-term, even if we expect economic growth to subsequently improve. Consequently, we remain tactically bearish and cyclically bullish towards Chinese stocks: medium-term investors who are already positioned in favor of China-related assets should stay long, whereas investors who have not yet moved to an overweight stance should wait for a better buying opportunity to emerge over the coming few months. Jing Sima China Strategist JingS@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Outlook “Fourth Quarter 2019 Strategy Outlook: A “Show Me” Market”, dated October 4, 2019, available at gis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report “China Macro And Market Review”, dated October 2, 2019, available at cis.bcaresearch.com 3 Announcement of the People’s Bank of China on Improving Loan Prime Rate (LPR) Formation Mechanism, August 19, 2019, available at http://www.pbc.gov.cn/en/3688110/3688172/3877490/index.html 4 PBC Official Answers Press Questions on Improving Loan Prime Rate (LPR) Formation Mechanism, August 20, 2019, available at http://www.pbc.gov.cn/en/3688110/3688172/3877865/index.html 5 Announcement of the People’s Bank of China No.16, August 27, 2019, available at http://www.pbc.gov.cn/en/3688110/3688172/3881177/index.html Cyclical Investment Stance Equity Sector Recommendations
In the latest Special Report we analyze historical sector performance since 1960 during deflationary periods that we define as two consecutive quarters of negative corporate sector price deflator growth. We find that following our deflationary signal, defensives are up 1.4% in relative terms on a 6-month horizon, while cyclicals are down 2.5%. We also note an inflection point around the 12-month mark as cyclicals start to recover their losses moving from -2.5% to just -0.21%, while defensives are giving up their gains moving from 1.38% to 0.76%. Similarly, if we look 24 months out, we observe that cyclicals are outperforming the market by 0.5% (largely driven by tech), and defensives are lagging the market by -1.2% (dragged by telecom and utilities) signaling that the market has recovered. To see a more in-depth discussion of the sector specific dynamics, please refer to this Monday’s Special Report.
Inflationary pressures remain muted in the U.S., which supports growth in two ways. First, muted inflation allows the Fed to maintain accommodative monetary conditions. In the absence of crippling debt-servicing costs, easy policy guarantees a continued…
Highlights Corporate Bonds: High corporate debt levels will be a problem for corporate bond investors during the next downturn, but spreads will not respond to them until inflationary pressures mount and monetary policy turns restrictive. Maintain an overweight allocation to corporate bonds versus Treasuries, with a preference for the Baa and high-yield credit tiers. MBS: Agency MBS spreads are competitive with high-rated (Aaa, Aa, A) corporate bonds, and look even more attractive on a risk-adjusted basis. We recommend that investors swap the Aaa, Aa and A-rated corporate bonds in their portfolios for agency MBS. Municipal Bonds: Investors should upgrade municipal bonds from neutral to overweight, given the recent back-up in Municipal / Treasury yield ratios. Within munis, investors should retain a preference for long-maturity Aaa-rated bonds, where yields are most compelling. Feature We attended BCA’s annual Investment Conference last week. The event always provides a good opportunity to hear from some expert panelists and find out what issues are front and center in our clients’ minds. More than anything else, two themes kept popping up in the different presentations and in conversations with attendees: Large corporate debt balances Under-priced inflation risk We can’t help but see a strong connection between the two. On Corporate Debt The consensus among panelists and attendees was very much in line with our own view: Highly levered balance sheets will be a problem for corporate bond investors during the next default cycle, but don’t help us determine when that default cycle will occur. Chart 1 shows that, despite the persistent increase in the debt-to-profits ratio, corporate bankruptcies are well contained. We examined the reasons for this divergence in a recent report, concluding that accommodative monetary policy is holding down the default rate by keeping interest costs low and giving banks the confidence to roll over maturing debt.1 Essentially, banks will look through signs of deteriorating corporate balance sheet health until the Fed shifts to a more restrictive policy stance. Chart 1Corporate Balance Sheets Are In Bad Shape, But Defaults Are Low On Inflation This is where inflation becomes important. The Fed is currently running an accommodative monetary policy because many years of low prices have convinced investors that inflation might never return. As a result, the 10-year TIPS breakeven inflation rate is only 1.53%, well below the 2.3% - 2.5% range consistent with the Fed’s target. The Fed must maintain an accommodative policy stance until it achieves its goal of re-anchoring inflation expectations. Only then will monetary policy turn restrictive, raising the risk of a corporate default cycle. We have long held the view that a 10-year TIPS breakeven inflation rate above 2.3% would cause us to turn much more cautious on corporate credit. It might take many months of core inflation printing near the Fed’s target before investors start to believe that it will stay there indefinitely. Many conference panelists thought that inflation risks are currently under-priced, and while we tend to agree that it is premature to declare the death of the Phillips curve, we expect it will still take some time before inflation expectations hit our 2.3% - 2.5% target range. We have shown in prior research that inflation expectations adapt only slowly to changes in the actual inflation data.2 At present, the fair value reading from our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate is only 1.94% (Chart 2). This fair value will move higher if inflation continues to print near current levels, but that process will take some time. In other words, it might take many months of core inflation printing near the Fed’s target before investors start to believe that it will stay there indefinitely. Chart 2Adaptive Expectations Model Chart 3Inflation Not Far From Target While the adaptive process might take a long time, it’s important to note that inflation is already quite close to the Fed’s target. Trailing 12-month trimmed mean PCE inflation came in at 1.96% in August, while year-over-year core PCE hit 1.77% (Chart 3). Trimmed mean inflation has been more stable than other inflation measures since the financial crisis, and core PCE has tended to drift toward the trimmed mean over time. On Corporate Debt & Inflation In our view, the two themes of high corporate debt and under-priced inflation risk are tightly linked. It has taken a very long time for the economy to recover from the financial crisis. As a result, inflation has been low for a prolonged period and the Fed has been forced to maintain an accommodative policy stance. That accommodative policy stance encourages banks to extend credit, and encourages firms to issue debt. Eventually, inflation pressures will mount, the Fed’s policy will turn restrictive and weak corporate balance sheets will be exposed. Only then, will corporate spreads widen significantly. Until that time, the pertinent question is whether corporate spreads offer adequate compensation for the risk that inflationary pressures emerge earlier than anticipated. For now, our answer is yes, with the caveat that the risk/reward trade-off is more attractive in the lower credit tiers. The 12-month high-yield breakeven spread is very attractive, well above its historical median (Chart 4). But within investment grade, we view only the Baa-rated credit tier as offering adequate compensation (Chart 4, bottom panel). There are better alternatives to owning Aaa, Aa and A-rated corporate bonds, as discussed in the next section. Chart 4Corporate Bond Valuation Favor Agency MBS Over High-Rated Corporate Credit Chart 5MBS More Attractive Than High-Rated Corporate Bonds As noted above, investment grade corporate bonds rated A or higher don’t offer much expected compensation at current spread levels. In fact, our prior research notes that their spreads are already below our cyclical targets.3 But on the plus side, the average option-adjusted spread (OAS) for conventional 30-year agency MBS has widened in recent months and now looks like an attractive alternative to high-rated corporate credit. We recommend that investors shift out of Aaa, Aa and A-rated corporate credit and into agency MBS for three reasons. 1) Expected Compensation Is Competitive The average OAS for conventional 30-year agency MBS now stands at 52 bps. This is only 6 bps below the average OAS offered by a Aa-rated corporate bond, and 37 bps less than that offered by an A-rated credit (Chart 5). That’s not bad for a Aaa-rated bond with agency backing. 2) Risk-Adjusted Compensation Is Stellar MBS spreads look much more attractive when we consider the risk profile. Specifically, when we consider that the average duration of the MBS index has fallen sharply this year, while the average duration of the investment grade corporate bond index has risen (Chart 5, panel 2). In fact, the average duration of the MBS index is only 2.9, compared to 7.8 for an A-rated corporate bond. This means that the MBS spread needs to widen by 18 bps over the next 12 months for an investor to see losses, while the A-rated spread needs to widen by only 11 bps (Chart 5, bottom panel). We recommend that investors shift out of Aaa, Aa and A-rated corporate credit and into agency MBS. Because MBS exhibit negative convexity, their duration declines when yields fall. By contrast, non-callable investment grade corporate bonds have positive convexity and have seen their durations rise. This means that, all else equal, negatively convex securities start to look more attractive on a risk-adjusted basis after a large decline in bond yields. This is also the main reason why negatively convex high-yield corporate bonds currently look much more attractive than investment grade corporate bonds.4 Interestingly, MBS did not look so attractive relative to corporate bonds in 2015/16, the last time that MBS index duration fell sharply. That’s because corporate bond spreads also widened during that period. This time around, corporate bond spreads have been stable as MBS index duration has plunged. Unless you think that Treasury yields have further downside, which we do not,5 agency MBS look like a good buy. 3) Macro Risks Are Lower While, as discussed above, we are not yet sounding the alarm about the macro risks to corporate bonds, we are even less concerned about the macro risks surrounding agency MBS. Mortgage refinancing activity is the most important macro driver of MBS spreads, and it should stay relatively low for a very long time. At such low mortgage rates, most homeowners have already had an opportunity to refinance, so refi burnout is currently very high. This is obvious when we observe that there was only a small spike in refi activity this year, despite a very large decline in mortgage rates (Chart 6). Chart 6Muted Refi Activity Will Keep Nominal Spreads Low Chart 6 also shows that the nominal MBS spread is highly correlated with refi activity, and that it remains near its historical tights. This spread contains both the OAS – which is a proxy for an MBS investor’s expected return – and the portion of the spread that is expected to be lost as a result of prepayment activity. The fact that the OAS is reasonably elevated compared to history while the overall nominal spread remains low means that MBS are pricing-in very little buffer for prepayment losses. Given the macro back-drop, this seems appropriate. Beyond refi risk, we also note that the credit quality of outstanding mortgages remains very high. The median FICO score on new mortgages has barely come down since the financial crisis (Chart 7). Further, while mortgage lending standards have been easing for the bulk of the post-crisis period, the Fed’s July Senior Loan Officer survey reported that the banks that view lending standards as tighter than the post-2005 average outnumber those that view standards as easier. Stronger housing activity data generally lead to higher mortgage rates, which in turn limit refi activity. Finally, there is very little reason to be concerned about significant weakness in housing activity. Of the six major housing activity data series that we track, all have rebounded sharply since this year’s drop in mortgage rates (Chart 8). Stronger housing activity data generally lead to higher mortgage rates, which in turn limit refi activity. Chart 7Mortgage Lending Standards Are Tight Chart 8Housing Activity Hooking Up Bottom Line: Agency MBS spreads are competitive with high-rated (Aaa, Aa, A) corporate bonds, and look even more attractive on a risk-adjusted basis. We recommend that investors swap the Aaa, Aa and A-rated corporate bonds in their portfolios for agency MBS. Upgrade Municipal Bonds On July 23, we advised investors to reduce municipal bond exposure from overweight to neutral.6 The rationale was purely valuation driven. We saw no immediate signs of municipal credit distress, but noted that yields were simply too low relative to the alternatives. Today, we similarly see no signs of immediate credit distress. In fact, municipal bond ratings upgrades continue to outpace downgrades, our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage is strong (Chart 9).7 Chart 9Muni Credit Quality Is Not A Concern The difference, however, is that yield ratios have rebounded dramatically since early August, and municipal bonds have once again become attractive (Chart 10). Chart 10Munis Attractive Once Again Bottom Line: Investors should upgrade municipal bonds from neutral to overweight, given the recent back-up in Municipal / Treasury yield ratios. Within munis, investors should retain a preference for long-maturity Aaa-rated bonds, where yields are most compelling. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 4 The high-yield bond index is negatively convex because most high-yield credits carry embedded call options. Investment grade corporate bonds tend to be non-callable. 5 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 For further details on our Municipal Health Monitor please see U.S. Bond Strategy Special Report, “Trading The Municipal Credit Cycle”, dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights U.S. growth will soon rebound thanks to robust drivers of domestic activity, and strengthening money and credit trends. The U.S. Federal Reserve will maintain an easing bias and will expand its balance sheet again. A growing Fed balance sheet will catalyze an underlying improvement in global liquidity conditions and boost the global economy. Brexit, China and Iran are key risks. The dollar will depreciate, bond yields will rise further and silver will outperform gold. Equities will surpass bonds on both cyclical and structural investment horizons. Financials and energy are more attractive than tech and healthcare. Thus, Europe is becoming increasingly appealing relative to the U.S. Feature Global equities are only 5% below their January 2018 all-time highs and the S&P 500 is close to breaking out above its July 2019 record. Meanwhile, yields are rebounding and value stocks are crushing momentum plays. Are these trends durable? Global growth is the key. If economic activity around the world can stabilize and ultimately improve, then stocks will break out and bond prices will suffer in the coming year. Otherwise, these recent financial market developments will undo themselves. Even if current activity remains weak, the outlook for global growth is looking up, despite trade wars, Brexit, Middle East tensions and problems in the interbank market. Therefore, we continue to favor stocks over bonds, because the backup in yields has further to go. If the dollar weakens, our pro-risk stance will only strengthen. U.S. Growth Drivers Are Healthy Chart I-1Recession Indicators Are Flashing A Yellow Flag The U.S. is near the end of a potent mid-cycle slowdown, but a recession will be avoided. Current conditions support an improvement in U.S. activity next year, even if key recessionary indicators, such as the yield curve and the annual rate of change of the Leading Economic Indicator, are still sending muddy signals (Chart I-1). U.S. growth will intensify because of five fundamental factors that will ultimately push the LEI higher and force the yield curve to re-steepen: A budding housing rebound, robust household spending, a stabilizing manufacturing sector, limited inflationary pressures, and a pick-up in money and credit trends. Housing The housing market has stabilized, buoyed by strong household formation, decent affordability, passing of the shock created by the cap in state and local tax deductions, and a 110-basis point collapse in mortgage yields since November 2018. Housing market indicators are finally catching up with leading variables, such as mortgage applications. In the past nine months, the NAHB housing market index has recovered nearly two-thirds of its decline since December 2018. Building permits and housing starts are at their highest levels since 2007, despite a significant fall last year. Even existing home sales have increased by 11% since December and are tracking the stimulation offered by lower borrowing costs (Chart I-2). Chart I-2The Housing Recovery Is Real Residential investment should soon boost economic activity after curtailing the level of GDP by 1% over the past six quarters. Moreover, rebounding housing activity implies that policy is not constraining growth. The real estate sector is historically the most sensitive to monetary conditions. Households Are Still Doing Well Core U.S. real retail sales continue to grow at a more than 4% annual pace and the Atlanta Fed GDPNow model forecasts a healthy 3.1% annual rise in consumer spending in the third quarter. This resilience is particularly impressive in the face of economic uncertainty and an ISM Manufacturing index below the 50 boom-bust line. Strong balance sheets are crucial to households. After 12-years of deleveraging, household debt has contracted by 37 percentage points to 99% of disposable income. Consequently, debt-servicing costs only represent 10% of disposable income, the lowest level in more than 45 years. Moreover, the household savings rate is a healthy 7.9% of after-tax income, which is particularly high in the context of the highest net worth ever and the lowest debt-to-asset ratio since 1985. Household income creates an additional support to consumption. Real disposable income is expanding at a 3% annual rate, despite slowing job creation. A tight labor market explains this apparent paradox. The employment-to-population ratio for prime-age workers is our favorite measure of labor market slack, and it has escalated to 79.7%, a level consistent with the 2.9% pace of annual growth in wages and salary (Chart I-3). The UAW strike at GM, the quits-rate at an 18-year high, and the difficulties small firms face to find qualified workers, all suggest that wages (and thus, consumption) will remain well underpinned (Chart I-3, bottom panel). Improving Manufacturing Outlook Manufacturing activity is set to rebound, despite the weakness in the ISM Manufacturing index. Recent industrial production numbers have already improved. Monthly IP expanded at a 0.6% monthly pace in August, but as recently as April, it was shrinking at a -0.6% rate. U.S. monetary conditions will continue to support asset prices and worldwide economic activity for the coming 18 months or so. The car sector will soon bottom. Weak auto production has been a primary diver of the recent global manufacturing slowdown. The automotive component of GDP contracted at a stunning 29.1% annual rate in the second quarter. However, U.S. light-vehicle sales are essentially flat. This dichotomy implies that the automobile sector’s inventories are contracting briskly (Chart I-4). Chart I-3A Tight Labor Market Supports Consumption Chart I-4Will Auto Production Rebound Soon? Capex should also recover. Last quarter, investment in structures and equipment subtracted from GDP growth. Before this, capex intentions had fallen significantly, now, the Philly Fed’s capital expenditure component is trying to stabilize. Capex must stop falling if global manufacturing is to strengthen. Limited Inflationary Pressures Inflationary pressures remain muted in the U.S., which supports growth in two ways. First, muted inflation allows the Fed to maintain accommodative monetary conditions. In the absence of crippling debt-servicing costs, easy policy guarantees a continued expansion. Secondly, low inflation keeps real income growth higher and increases the welfare of households. At 2.4%, core CPI is perky, but will soon roll over. Core goods prices have been driving fluctuations in aggregate core prices in the past three years, while service sector inflation has been stable at 2.7% during this period. Goods inflation will soon weaken for the following reasons: Chart I-5The Trade War Is Masking The Economy's Deflationary Tendencies Soft global economic activity will drive down global inflation. Inflation lags real activity and proxies for the global economy, such as Singapore’s GDP, point to weaker core CPI in the OECD (Chart I-5). This weakness will act as a drag on U.S. inflation because U.S. goods prices have a large international component. U.S. import prices peaked 15 months ago and they normally lead goods inflation by roughly a year and a half. The strength in the broad trade-weighted dollar, which has climbed by nearly 15% in the past 18 months to an all-time high, will hurt goods prices. U.S. capacity utilization declined through 2019 and remains well below the 80% level that historically causes core goods prices to overheat. The White House’s tariffs on China are boosting inflation but this effect will prove transitory. The tariffs are pushing up inflation for goods touched by the levies, while unaffected goods are experiencing deflation (Chart I-5, bottom panel). Given that tariffs have a one-off impact and that inflation expectations are hovering near record lows, inflation for tariffed-goods will converge toward the underlying trend in non-tariffed goods. Stronger Money And Credit Trends Money and credit trends indicate that the recent slump will not translate into a recession. Moreover, improving U.S. private-sector liquidity conditions argues that the mid-cycle slowdown is ending. Chart I-6Liquidity Indicators Point To A Growth Rebound U.S. broad money is recovering. After falling to 0.9% last November, U.S. real M2 growth is expanding at a 3% annual rate, a pace in keeping with the end of mid-cycle slowdowns. Moreover, money is also accelerating relative to credit issuance, which historically has pointed to quicker industrial activity. Similarly, our U.S. financial liquidity index is rapidly escalating, a development that normally precedes turning points in the ISM manufacturing (Chart I-6) index. Credit activity is also picking up. Corporate bond issuance is firming and, according to the Fed’s Senior Loan Officer Survey, demand for loans is rebounding across the board. The yield collapse is boosting credit growth across the G-10. Gold is outperforming bonds, which confirms that a mid-cycle slowdown occurred. If inflation is not a problem, then the yellow metal always underperforms bonds ahead of recessions. However, before mid-cycle slumps, gold consistently outperforms bonds (Chart I-7). Chart I-7Bonds Outperform Gold Ahead Of Recession More Fed Easing Imminent U.S. monetary conditions will continue to support asset prices and worldwide economic activity for the coming 18 months or so. The Fed will ease policy further and is a long way from tightening. Last week, the Federal Open Market Committee (FOMC) curtailed the fed funds target rate by 25 basis points to 2%. Additionally, while the median projection shows that Fed members expect no more rate cuts for at least the next 18 months, the reality is more subtle. Among 17 FOMC members, 7 expect to cut the fed funds rate by another 25 basis points by year end, and 8 foresee a lower policy rate in late 2020. The greenback is very expensive and will decline as global liquidity conditions improve. We are still on track for three 25-basis-point rate cuts this year. The Fed remains highly data dependent and is particularly sensitive to depressed inflation expectations. This means the Fed is acutely aware of the danger created by a sudden tightening in financial conditions. If by year-end the market has not moved away from discounting another cut in 2019, the FOMC will likely deliver this easing. Otherwise, financial conditions could suddenly tighten, which would hurt inflation expectations and the economic outlook. If global growth does not recover in early 2020, the Fed would probably cut rates an additional time in the first quarter, which would validate the current 12-month pricing in the OIS curve. Chart I-8Not Enough Excess Reserves The Fed will again increase the size of its balance sheet. Interbank markets have boxed the FOMC into adding welcomed stimulus to the global economy. Allowing commercial bank excess reserves to grow anew will have a greater positive impact for global growth compared with rate cuts alone. Last month, we highlighted the risks to the repo market created by the combination of the dwindling of excess reserves, the bloated securities inventory of primary dealers financed via repo transactions, and the growth in the issuance of Treasurys.1 These risks materialized last week, when the Secured Overnight Financing Rate (SOFR) suddenly spiked above 5% (Chart I-8). To calm the market, the Fed injected $75 billion each day last week starting Tuesday to bring repo rates closer to the Interest Rate on Excess Reserves (IOER). But this is not a long-term solution. Chart I-9Higher Excess Reserves Will Hurt The Dollar And Boost Global Growth Paradoxically, the crystallization of the repo market tensions is good news for the global economy because it will force the Fed to again expand its balance sheet as soon as next month. The supply of funds to the repo market needs to increase permanently, which means that banks’ excess reserves must re-expand. As we showed last month, higher excess reserves will hurt the U.S. dollar, lift EM exchange rates and boost global PMIs (Chart I-9). Higher excess reserves ease global liquidity conditions. The money injected will find its way to the rest of the world. The dollar trades 25% above its long-term, fair-value estimate of purchasing power parity. Therefore, a growing fiscal deficit indirectly financed by a larger Fed balance sheet will lead to a larger U.S. current account deficit, which in turn, will lift global FX reserves. As a result, the Fed’s custodial holdings of securities on behalf of other central banks will rise. Thus, global dollar-based liquidity will stop contracting relative to the stock of U.S. dollar-denominated foreign currency debt it supports (Chart I-10). Higher excess reserves will also ease global financial conditions. By boosting dollar-based liquidity, a larger Fed balance sheet will dampen offshore dollar interest rates. Moreover, rising excess reserves depreciate the greenback, which further cuts the cost of credit for foreign entities borrowing in U.S. dollars. This phenomenon is especially significant for EM. Therefore, we should see an easing of EM financial conditions, which are heavily dependent on EM exchange rates. Historically, looser EM financial conditions lead to stronger global growth (Chart I-11). Chart I-10High-Powered Liquidity Set To Improve Chart I-11Easier EM FCI Should Lead To Faster Growth Risks: The U.K., China And Iran While the outlook generally points to a rebound in global growth, which will create a positive environment for risk assets, the situations in the U.K., China, and Iran should be closely monitored. The U.K. Brexit remains a potential danger for the world even though our base case calls for a benign outcome. U.K. Prime Minister Boris Johnson’s gambit to push for a No-Deal Brexit to force the EU to make concessions could result in a miscalculation. Such a turn of events would plunge a European economy – already damaged by weak global trade – into recession. The dollar would strengthen and global financial conditions would tighten. Global growth would take another hit. Chart I-12U.K.: No Clear Winner Ahead Of A Potential Election Following this week’s Supreme Court unanimous ruling against Johnson’s decision to prorogue Parliament, No-Deal carries a less than 10% probability. Johnson lacks a majority in a Parliament staunchly against a hard Brexit and he is unable to call an election prior to the October 31st deadline to leave the EU. Therefore, a delay is the most likely outcome, which will allow the EU and the U.K. to reach a deal on the Irish backstop that Parliament can then ratify. Ultimately, the U.K. needs another election to break the current logjam, which could materialize in November or December. However, the Remain vote is split between Labour, Lib Dems, and the SNP, but the Brexit vote is not nearly as divided. (Chart I-12). Hence, Brexit will remain a risk lurking in the background even if it does not morph into a full-blown assault on global growth. China Chart I-13Chinese Stimulus Remains Too Tepid To Move The Needle China’s economic activity continues to soften. In August, industrial production and fixed-asset investment decelerated to 4.4% and 5.5%, respectively. Moreover, total social financing growth slowed on an annual basis and overall Chinese credit flows decreased as a share of GDP (Chart I-13). Chinese policy reflation remains too tepid to undo the drag created by trade uncertainty and the weakness in the marginal propensity to spend (Chart I-13, bottom panel). Sino-U.S. trade tensions have significantly decreased in recent months, but they will remain an important source of uncertainty for China and the world. China and the U.S. will again hold high-level talks next month, U.S. President Donald Trump has again postponed some of the tariff increases, and China is again buying mid-Western soybeans and pork. But last Friday’s cancelation of U.S. farm visits by Chinese officials reminds us that the situation is very fluid. Ultimately, China and the U.S. are long-term geopolitical rivals. Trump may be constrained by the 2020 election, but China could still drive a hard bargain. Hence, it is prudent to expect a stop-and-go pattern in the negotiations. Chart I-14Deflation Unleashes A Vicious Circle Of Higher Real Borrowing Costs A weak China will sow the seeds of its own recovery. In addition to the negative effect on capex intentions and credit demand of trade uncertainty, Beijing faces deteriorating employment and producer price inflation of -0.8% (Chart I-14, top panel). As PPI inflation becomes more negative, heavily indebted corporate borrowers face rising real interest rates (Chart I-14, bottom panel). This higher cost of debt weakens an already vulnerable economy, unleashing a vicious circle. Chinese policymakers are unlikely to tolerate this situation for much longer. The cumulative 400-basis point cuts in the reserve requirement ratio since April 2018 are steps in the right direction, but are not yet enough. The dovish change to the Politburo’s and State Council’s language indicates that greater stimulus is forthcoming. Thus, credit expansion, local government special bonds issuance and fiscal stimulus will become even more prevalent in the final quarter of 2019. This policy should noticeably goose economic activity in 2020, which will help global growth accelerate. Iran Tensions are re-flaring and a spike in oil prices would threaten the fragile global economy. However, this remains a risk, not a central case. In the July issue of The Bank Credit Analyst, we warned that tensions with Iran were the greatest visible risk to global growth and risk assets.2 This danger came into focus last week with the drone attacks on the Khurais oil field and Abqaiq oil processing facility in Saudi Arabia, which curtailed global oil supply by an unprecedented 5.7 million bbl/day, or 5.5% of global demand. Unsurprisingly, Brent prices quickly surged by 12% to $68/bbl. Chart I-15Higher Energy Efficiency Makes The World More Robust A durable spike in oil prices would push the global economy into a recession, especially while the global economy is already on weak footing. Chief U.S. Equity Strategist Anastasios Avgeriou reminded his clients3 that according to a seminal 2011 paper by Prof. James D. Hamilton, a doubling of oil prices preceded all but one of the post-war recessions.4 However, an oil-induced recession would likely be shallow because the oil intensity of the global economy has significantly declined in the past 30 years (Chart I-15). Moreover, global fiscal authorities would respond forcefully to an economic contraction, which would also limit the impact of the shock. There is a low likelihood that oil will double by year-end. It would require Brent prices to surge to $100/bbl. Saudi Arabia has already stated that production will return to pre-crisis levels in the coming days and not a single shipment will be missed. This promise implies further inventory drawdowns. Aramco also expects to achieve maximum output by late November. Moreover, higher oil prices will encourage further activity in the U.S. shale patch. Consequently, oil prices are unlikely to surge by another $35/bbl in the next three months. However, Brent prices could climb to $75/bbl next year, because while oil demand is set to recover, investors must also embed a greater risk premium against Saudi supply disruptions. A military conflict with Iran is a tail risk, but if it were to materialize, crude prices would surge by $35/bbl or more in an instant. According to Matt Gertken, BCA’s Chief Geopolitical strategist, the appetite for such a conflict is low in the U.S.5 President Trump has isolationist instincts and does not want to be mired in another conflict. Investment Implications The Dollar The dollar has significant downside. The greenback is very expensive and will decline as global liquidity conditions improve (Chart I-16). These dynamics reflect the countercyclical nature of the dollar and also lead to strong greenback momentum, both on the way up and down. The dollar would weaken in response to improving global growth and liquidity conditions, the lower dollar would ease global financial conditions, further stimulating the global economy. A virtuous circle could then emerge. Chart I-16Increasing Financial Liquidity Will Hurt The Greenback Repatriation flows will also move from a tailwind to a headwind for the greenback. Prompted by both rising risk aversion and the Trump tax cuts, U.S. economic agents have repatriated $461 billion in the past 18 months. This has created powerful support for the USD (Chart I-17). The effect of the tax cut is vanishing and rising global growth will incentivize U.S. households and firms to buy foreign assets more levered to the global business cycle. In the process, they will sell the dollar. Chart I-17Repatriation Will Not Support The Dollar For Much Longer The euro will continue to behave as the anti-dollar, a consequence of the pair’s plentiful market liquidity. Moreover, the euro trades at a 17% discount to its purchasing power parity equilibrium. After last week’s rate cut and QE announcement, the European Central Bank has no more room to ease. Instead, the recent fall in peripheral bond spreads is loosening European financial conditions, which is boosting European growth prospects. This makes the euro more attractive. Bonds And Precious Metals Safe-haven yields will have significant upside in the coming 12 to 18 months. As we highlighted last month, bonds are so expensive, overbought and over-owned that they suffer from an extremely elevated probability of negative cyclical returns (Chart I-18, left and right panels). Moreover, excess reserves will once again grow when the Fed re-starts to expand its balance sheet. Higher excess reserves lead to a steeper yield curve slope (Chart I-19). Short rates have limited downside, therefore, the curve can only steepen via higher 10-year yields. Chart I-18AValuation And Technicals Point Toward Higher Yields In 12 Months (I) Chart I-18BValuation And Technicals Point Toward Higher Yields In 12 Months (II) Chart I-19Fed Purchases Will Steepen The Curve Short-term dynamics are more complex. Treasury yields have climbed by 21 basis points since their September 3rd low, mostly on the back of decreasing trade tensions. In previous mid-cycle slowdowns, bond price tops only emerged after the ISM bottomed. We are not there yet. We expect substantial short-term volatility in yields in view of the unpredictable Sino-U.S. negotiations and the current lack of pick-up in global growth. During this transition process, cyclical investors should use bond rallies such as the current one to build below-benchmark duration positions in their fixed-income portfolios. Within precious metals, we continue to prefer silver to gold. We have favored precious metals since late June,6 but higher bond yields are negative for gold. However, central banks are maintaining a dovish bias aimed at lifting inflation breakevens back to their historical norm of 2.3% to 2.5%. This process increases the chance that the economy will overheat late next year. For the next 12 months, rising inflation expectations, not higher real rates, will push up bond yields. Combined with a weaker dollar, this configuration is mildly bullish for gold. Silver has a higher beta and more industrial uses than gold, which will allow for a period of outperformance if global growth increases. In this context, the silver-to-gold ratio, which stands at its 6th percentile since 1970, is an attractive mean-reversion play (Chart I-20). Chart I-20The Silver-Gold Ratio Is A Bargain Equities Investors should continue to favor stocks relative to bonds in the next year. Equities perform well up to six months before a recession starts (Table I-1). Moreover, our monetary and technical indicators are upbeat (see Section III). Additionally, sentiment surveys do not show rampant investor complacency (see Section III), which limits risks from a contrarian perspective. Meanwhile, yields have upside, which implies an outperformance of stocks versus bonds. Table I-1The S&P 500 Doesn’t Peak Until Six Months Before A Recession The short-term picture is more complex. P/E ratio expansion powered 90% of the S&P 500’s gains since it bottomed in December 24, 2018, and according to our model, U.S. operating earnings will contract for at least eight more months (Chart I-21). Thus, if yields mount through the rest of the year, multiples will likely contract. The S&P 500 is set to continue to churn over that time frame. Chart I-21U.S. Profits Still Have Downside In this context, strategy dictates investors focus on internal stock market dynamics. Namely, investors should favor financials and energy at the expense of tech and healthcare for the following reasons: Rising bond yields lift financials’ net interest margins. They also hurt multiples for tech stocks, which carry a large percentage of their intrinsic value in long-term cash flows and their terminal value. Thus, rising yields correlate with an outperformance of financials relative to tech (Chart I-22). Moreover, financials’ valuations and technicals are very depressed relative to tech, while comparative earnings estimates are equally morose (Chart I-23). Finally, our U.S. Equity Strategy team expects buybacks by financials to increase significantly.7 Chart I-22If Yields Rise, Financials Will Beat Tech Chart I-23Valuations, Technicals And Sentiment Favor Financials Over Tech Rising yields also hurts healthcare stocks. Additionally, the rising popularity of Democratic progressives like Senator Elizabeth Warren requires investors embed a risk premium in the price of healthcare stocks (Chart I-24). The progressives want to nationalize healthcare insurance and compress healthcare profit margins, from drugs to hospitals. Chart I-24The Rise Of The Progressives Requires A Risk Premium In Health Care Stocks We have used energy stocks as a hedge against rising tensions in the Middle East. Now, our U.S. Equity Strategy colleagues have become more positive on this sector. Energy valuations and technicals are very attractive relative to the S&P 500 (Chart I-25).8 Energy stocks will outperform if global growth recovers and lifts global bond yields These sectoral recommendations argue investors should soon begin to favor European relative to U.S. stocks. Financials and energy are overrepresented in European equities while tech and healthcare are large overweight’s in the U.S. (Table I-2). Moreover, European activity is more sensitive to global economic momentum than the U.S. Thus, when global yields rally and the world economy stabilizes, European stocks will outperform their U.S. counterparts (Chart I-26). Additionally, European banks trade at 0.6-times book value which makes them the ultimate value play, one highly geared to easier European financial conditions and higher yields. Chart I-25Energy Is A Compelling Buy Table I-2Overweighting Europe Is Consistent With Our Sectoral RecommendationsChart I-26Europe Will Soon Outperform The U.S. Chart I-27Long-Term Investors Should Favor Stocks Over Bonds These sectoral biases are also consistent with value stocks outperforming growth equities. However, as Xiaoli Tang from BCA’s Global Asset Allocation service argues in Section II, the value-versus-growth question is a complex one that needs to be differentiated across geographies and equity size. Finally, long-term investors should also favor stocks over bonds. According to BCA Chief Global Strategist Peter Berezin, global stocks at their current valuations offer an expected 10-year real return of 4.2%. By historical standards, these are not elevated returns, but they are still much more generous than government bonds. Based on their dividend yields, U.S., Japanese and European equities need to fall by 18%, 28% and 40% before underperforming bonds on a 10-year basis, respectively.9 This is a large margin of safety (Chart I-27). We prefer foreign stocks with their more attractive valuations and local-currency expected returns. Additionally, the dollar is expensive and will weaken in a 5- to 10-year investment horizon. Mathieu Savary Vice President The Bank Credit Analyst September 26, 2019 Next Report: October 31, 2019 II. Value? Growth? It Really Depends! Investors should pay particular attention to definition and methodology when evaluating value versus growth strategies, both academically and in practice. Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap universe. Small-cap investors should focus on value. Large- and mid-cap investors should not be making bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels. GAA remains neutral on value versus growth, but prefers to use sector positioning (cyclicals versus defensives, financials versus tech and health care) and country positioning (euro area versus U.S.) to implement style tilts. Investing by way of style is as old as investing itself. Value versus growth has been one of the most frequently asked questions among our clients of late, particularly given the sharp style reversal in recent weeks. In this report, we attempt to answer some of the most often-asked questions on value versus growth. We have arranged these questions into five separate sections: First, we look at 93 years of history of the Fama-French value and growth portfolios to see how value, growth, and size have interacted over time, because academics have mostly used the Fama-French framework. Second, we look at how comparable U.S. style indices are, including the S&P, the Russell and the MSCI, since practitioners mostly use these commercial indices as their benchmarks. Third, we investigate if international markets share the same value-growth performance cycles as the U.S., using the MSCI suite of value-growth indices (since MSCI is the only index provider that produces value-growth indices for each market under its global coverage). Fourth, we investigate if pure exposure to value and growth can actually improve the value-growth performance spread by comparing the pure style indices from the S&P and the Russell to their standard counterparts. Finally, we present the GAA approach to style tilts in a section on our investment conclusions. 1. Is It True That Value Outperforms Growth In The Long Run? There has been overwhelming academic evidence supporting the existence of the value premium.10 Academically, the “value premium”, also known as the HML (high minus low) factor premium, or the value outperformance, is defined as the return differential between the cheapest stocks and the most expensive. Even though Fama and French used book-to-price as the sole valuation criterion,11 many researchers have combined book-to-price with other valuation measures such as earnings-to-price, sales-to-price, dividend yield,12 and so on. There is also academic evidence suggesting that “value outperformance is almost non-existent among large-cap stocks.”13 What is more, in 2014 Fama and French caused a huge stir by publishing “A Five-Factor Asset Pricing Model” working paper demonstrating that “HML is a redundant factor” because “the average HML return is captured by the exposure of the HML to other factors” (such as size, profitability, and investment pattern) based on U.S. data from 1963 to 2013.14 Asset owners and allocators should pay special attention when selecting benchmarks for value and growth. For non-quant practitioners, especially the long-only investors, value and growth are two separate investment styles, even though the style classification shares the same principle as the academic “value factor.” Their definitions vary, as evidenced by how S&P Dow Jones, FTSE Russell, and MSCI define their value and growth indexes (see next section on page 7). In general, value stocks are cheap, with lower-than-average earnings growth potential, while growth stocks have higher-than-average earnings growth potential but are very expensive. The indices published by commercial index providers do not have very long histories, however. Fortunately, Fama and French also provide value-growth-size portfolios on their publicly available website.15 Table II-1 shows that for 93 years, from July 1926 to June 2019, U.S. value portfolios in both large-cap and small-cap buckets based on the well-known Fama-French approach have returned more than their growth counterparts, no matter whether the portfolios are equal-weighted or market-cap-weighted. Most strikingly, equal-weighted small-cap value outperformed its growth counterpart by over 10% a year in absolute terms, and has more than doubled the risk-adjusted return compared to its growth counterpart. Table II-1Fama-French Value-Growth-Size Portfolio Performance* Some media reports have claimed that value stocks are “less volatile” because they are on average “larger and better-established companies.”16 This may be true for some specific time periods. For the 93 years covered by Fama and French, however, this common belief is not supported. In fact, value portfolios in both the large- and small-cap universes have consistently had higher volatility than growth portfolios, no matter how the components are weighted. The excess returns, however, have more than offset the higher volatilities in three out of four pairs, with the exception being market cap-weighted large-cap growth, which has a slightly higher risk-adjusted return due to much lower volatility than its value counterpart. From a very long-term perspective, the value outperformance does come from taking higher risk. Further investigation shows that the superior long-run outperformance of value relative to growth came mostly in the first 80 years of Fama and French’s 93-year sample. In more recent years since 2007, however, value has underperformed growth significantly in three out of the four Fama-French value-growth pairs, with the equal-weighted small-cap value-growth pair being the sole exception, as shown in Table II-2. Even though the equal-weighted small-cap value has still outperformed its growth counterpart in the most recent period, the hit ratio drops to 54% compared to 76% in the first 80 years, while the magnitude of average calendar-year outperformance drops to a meager 1.3%, compared to 12.5% in the first 80 years. Table II-2The Fight Between Value And Growth* Statistical analysis is sensitive to the time period chosen. How have value and growth been performing over time? Chart II-1 shows the long-term dynamics among value, growth, and size. The following conclusions are clear: Chart II-1Fama-French Value-Growth-Size Peformance Dynamics* Value investors should favor small caps over large caps, while growth investors should do the opposite, favoring large caps over small caps, albeit with much less potential success (Chart II-1, panel 1). Small-cap investors should favor value stocks over growth stocks (panel 2). Value outperformance in the large-cap space (panel 3) is much weaker than in the small-cap space (panel 2). Fama and French define small and large caps based on the median market cap of all NYSE stocks on CRSP (Center for Research In Security Prices), then use the NYSE median size to split NYSE, AMEX and NASDAQ (after 1972) into a small-cap group and a large-cap group. The value and growth split is based on book-to-price, with stocks in the lowest 30% classified as growth, and the highest 30% as value. Interestingly, small-cap value and small-cap growth account for only a very small portion of the entire universe, as shown in Charts II-2A and II-2B. Value stocks’ average market cap is about half of that of growth stocks, in both the large- and small-cap universes (panel 3 in Charts II-2A and II-2B). Again, this does not support some media claims that value stocks are larger and better-established companies. However, it does add further support to the claim that all investors should favor small-cap value stocks. Unfortunately, “small-cap value” is a very small universe. As of June 2019, the CRSP total U.S. equity market cap was $26.2 trillion, with small-cap value accounting for only 1.5% (about $383 billion); even large-cap value comprises only a relatively small weight, 13% (US$3.5 trillion). Chart II-2ASmall-Cap Value-Growth Portfolios* Chart II-2BLarge-Cap Value-Growth Portfolios* The U.S. market is dominated by large-cap growth stocks with a heavy weight of 56% (US$14.7 trillion, as of June 2019). This is encouraging because academic research does show that the value premium among large caps is weak. But the large-cap value weakness mostly started from 2007, after 80 years of strength relative to large-cap growth (Chart II-1, panel 3). The Fama-French approach is widely used in academic research, partly due to its long history from 1926. For non-quant practitioners, especially long-only investors, however, commercial indexes from FTSE Russell, S&P Dow Jones, and MSCI are more often used as performance benchmarks. In this report, we study a series of commercial value-growth indexes in the U.S. and globally to shed light on value-growth dynamics, and how asset allocators can incorporate them into their decision-making processes. 2. Not All U.S. Style Indexes Are Created Equal Three major index providers have style indices. They are FTSE Russell (which launched the industry’s first set of value-growth indexes in 1987), S&P Dow Jones, and MSCI. MSCI is the only provider that has a full suite of value-growth indices for all individual markets under coverage. While all three provide “standard” style indices that include the full component of the parent index, the FTSE Russell and the S&P Dow Jones also provide “pure” style indices. There are two major differences between “standard” and “pure” style indices: 1) the standard indices are market-cap weighted, while the “pure” indices are weighted based on style score. 2) Standard value and standard growth have overlapping components, while pure value and pure growth do not share any common components. We prefer to use sector and country positioning to implement style tilts tactically. Other than book-to-price, the value variable used by the Fama-French approach, the three providers have added different variables in the determination of value and growth, as shown in Table II-3. This also reflects the evolution of the industry’s understanding on value and growth. For example, when MSCI first launched its style index in 1997, it used only book-to-price, but changed its approach in May 2003 to the current “multi-factor two-dimension” framework. Table II-3Value-Growth Index Criteria Because of the differences in index construction methodology, value-growth indices for the U.S. have behaved differently. The S&P 500, the Russell 1000, and the MSCI standard (large and mid-cap) indices are widely followed institutional benchmarks, with back-tested history dating to the 1970s. Chart II-3 shows the relative value/growth performance dynamics from the three index providers, together with that from Fama and French (market value-weighted, to be consistent with the approach from the index providers). One can observe the following: Chart II-3Which Value/Growth? None of the three pairs looks exactly like Fama-French’s market-cap value-weighted value/growth. This raises the question of how historical analysis based on the long history of Fama-French value/growth portfolios can be applied to the commercial indices. In the first cycle from 1975 to February 2000, all three index pairs made a round trip, with flat performance between value and growth. Also, even though the S&P 500 and Russell 1000 were more closely correlated with one another than with the MSCI, the three were quite similar. In the current cycle that began in February 2000, however, Russell value/growth has rebounded much more strongly than the other two. But in the down period that started in 2007, the three indices performed in line with each other, as shown in Table II-4. Table II-4U.S. Style Index Performance* In addition, the difference between S&P and Russell does not just lie between the S&P 500 and the Russell 1000. It actually exists in every market-cap segment, as shown in Chart II-4. Unfortunately, MSCI does not provide history from 1975 for the detailed cap segments. In the current cycle since February 2000, S&P value rebounded the least between 2000 and 2006. Why? Chart II-4Know Your Benchmark Further investigation reveals some interesting observations, as shown in Chart II-5. Chart II-5Value/Growth: Russell Vs. S&P At the aggregate level, the S&P 1500, the Russell 3000 and their respective style indices have performed largely in line with one another in the most recent cycle starting from February 2000 (Chart II-5, panel 4), reflecting the industry trend of index convergence. In different market cap segments, however, the divergence is still prominent, especially in the small-cap space (panel 1). The S&P 600 has consistently outperformed the Russell 2000 in both the value and growth categories. In addition to different style factors, this consistency also reflects different universes, size distribution, and sector exposure, as explained in an earlier GAA Special Report on small caps.17 Managers with Russell 2000 as their performance benchmark could simply beat it by doing a total-return-performance swap between the Russell 2000 and the S&P 600. Bottom Line: Asset owners and allocators should pay special attention when selecting benchmarks for value and growth. 3. How Have Value And Growth Performed Globally? MSCI is the only index provider that also produces value-growth indices for each equity market under its global coverage, using the same methodology. Unfortunately, only the “standard” (i.e., large- and mid-cap) universe has a long history, dating from December 1974. Charts II-6A and II-6B show the value/growth dynamics in major DM and EM markets. The relative performance of MSCI DM value versus growth shares a similar pattern to that of the U.S. in the latest cycle since 2000, but looks very different in the period before 2000 (Chart II-6A). The ratio of EM large- and mid-cap value versus growth did not peak until February 2012, about five years after the peak of its DM peer (Chart II-6B, panel 1). On the other hand, EM small-cap value has resumed its outperformance versus growth since early 2016 after having peaked around the same time as its large-cap counterpart. Chart II-6AIs Value Dead In DM? Chart II-6BIs Value Dead In EM? The global value/growth dynamics also show that the “value outperforming growth” effect is more prominent in the small-cap space. But why has small value also underperformed small growth in most DM markets? Our explanation is that the EM universe is much less efficient than the DM universe because there are not many quant funds dedicated to the EM small-cap space – in addition to the fact that, in general, EM small caps are much smaller than those in DM markets. This is also in line with our finding that, in general, factor premia are more prominent in the EM universe.18 Bottom Line: Value premium is more prominent in non-U.S. markets, especially the EM small-cap universe. 4. Do Pure Style Indices Improve Performance? Both S&P Dow Jones and FTSE Russell provide pure-value and pure-growth indices. Unlike the standard value-growth indices, which target about 50% of the parent market cap, the pure-style indices include only stocks with the strongest value and growth characteristics. There is no overlap between the two. In theory, the pure-style indices should outperform the standard-style indices because of their concentrated exposure to style factors. How do they do in reality? Table II-5 shows that in terms of absolute return, this is indeed the case for 14 out of the 18 pairs of indices from S&P and Russell for the period between 1998 and 2019. However, the higher returns from greater exposure to style factors have largely come from much higher volatility in 17 out of the 18 pairs. Pure style has higher volatility than standard style in general, the only exception being the Russell mid-cap value space. As such, on a risk-adjusted basis, pure style is not necessarily better. Table II-5Purer Is Not Necessarily Better Charts II-7A and II-7B show the different performance dynamics for the S&P and Russell families of style indices. For the S&P indices, pure growth has outperformed standard growth for the entire period in all three market-cap segments, but only the S&P 500 pure value outperformed its standard counterpart. Therefore, more concentrated exposure to style characteristics has improved the value-growth spread only in the large-cap space, but it has actually worsened the value-growth spread in the mid- and small-cap universes (Chart II-7A). Chart II-7AS&P Pure Styles* Chart II-7BRussell Pure Styles* For the Russell indices, it’s clear that there were a lot more tech stocks in its pure-growth indices leading up to the 2000 tech bubble, because pure growth shot up significantly more than the standard growth before the bubble burst, and also crashed more severely following it. Overall, only in the small-cap space did the value-growth spread improve by the more concentrated exposure to style factors. However, this improvement was not because of the outperformance of the pure-style relative to the standard indices. In fact, both pure value and pure growth in the small-cap universe underperformed their standard counterparts, but pure growth performed even worse (Chart II-7B and Table II-5). 5. Investment Conclusions Value and growth can mean very different things and behave very differently. Investors should pay special attention to the definitions and methodologies when evaluating style indices or strategies, both academically and in practice. Depending on an investor’s mandate, the following is recommended: Value investors should focus on non-U.S. markets, especially the emerging market small-cap universe. Growth investors should focus on large caps, especially the U.S. large-cap space. Small-cap investors should focus on value. Large-and mid-cap investors should not make bets between value and growth strategically. Tactical style rotation should be done only when valuation spreads reach extreme levels. Price-to-book is the only common variable used in the determination of value and growth by academics and practitioners. Its track record as a systematic return predictor has been poor, as shown in panel 2 of Charts II-8A and II-8B. Another factor we have a long history for is dividend yield. Its predictive power is even worse than that of price-to-book (panel 3). Chart II-8AValuation Is A Poor Timing Tool In The U.S. Chart II-8BValuation Is A Poor Timing Tool Globally Many factors have been used in conjunction with price-to-book by both academics and practitioners to time the rotation between value and growth. However, the results have been mixed. Regression models that correctly predicted in the past may not work in the future. For example, a regression model based on valuation spread and earnings-growth spread using data from January 1982 to October 1999 successfully predicted the rebound of value outperformance starting in early 2000,19 but the universal suffering of value funds over the past several years implies that this model may have given many false signals. Chart II-9 demonstrates how difficult it is to use regression models as a timing tool for value and growth rotation. A simple regression is conducted between value and growth return differentials (subsequent 60-month returns) and relative price-to-book. For data from December 1974 to July 2019, the r-squared for the MSCI world is 0.38 and for the U.S. it is 0.09. In hindsight, both models predicted the value outperformance starting in early 2000. However, the gaps between actual value and fitted value started to open, long before 2000. By late 1998, the gaps were already wider than the previous cycle lows, yet they continued to widen as value continued to underperform growth until February 2000. Chart II-9How Good Is The Fit? What should investors currently do, based on these models? The gaps are large, but not as large as in early 2000. At which point should investors start to shift into value given its more than 12 years of underperformance? We have often written that we prefer to use sector and country positioning to implement style tilts.20, 21 This preference has not changed. Value and growth indices have sector tilts that change over time. Currently, the S&P Dow Jones large- and mid-cap value indices have a clear overweight in financials but an underweight in tech and health care compared to their growth counterparts (Table II-6). Table II-6Sector Bets In Value And Growth Indices* Chart II-10Prefer Sector And Country Positioning To Style We have been neutral on value and growth, but would likely change this view if we change our country equity allocation between the U.S. and the euro area, and our equity sector allocation between cyclicals and defensives as well as between financials and information technology (Chart II-10). Xiaoli Tang Associate Vice President Global Asset Allocation III. Indicators And Reference Charts The S&P 500 will continue to churn this year. U.S. stocks have rebounded sharply through the month of September, yet, sentiment is neutral. Nonetheless, for now, stocks are likely to find it hard to meaningfully break above their July highs. Short-term momentum oscillators are overbought and U.S. profits still have downside. Because this year’s equity rally has been nearly entirely driven by multiples, this leaves equities vulnerable to any back-up in yields. As yields have not priced in any pick-up in growth, potential positive economic surprises are more likely to lift yields than stock prices. However, if growth disappoints, weak rates will cushion to blow to expected earnings. In line with this picture, our Revealed Preference Indicator (RPI) continues to shun stocks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuations and policy, investors should lean against the market trend. Global growth remains the biggest problem for stocks. Until the global economy finds a floor, the outlook for profits will be poor and our RPI will argue against buying equities. The outlook for next year remains constructive for stocks. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan is markedly improving. However, it continues to deteriorate in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Global yields remain very depressed at highly stimulatory levels. Moreover, money growth has picked up around the world, and global central banks are cutting rates and expanding their balance sheets again. As a result, our Monetary Indicator remains at its most accommodative level since early 2015. Furthermore, our Composite Technical Indicator might not be improving anymore but it is still very much in constructive territory. Therefore, unlike four years ago, equities are more likely to avoid the headwind created by their overvaluation, especially as our BCA Composite Valuation index continues to improve. 10-year Treasurys may have cheapened a bit since last month, but they remain very expensive. Moreover, when current overvaluation levels are met by our technical indicator being as massively overbought as it is today, safe-haven bonds experience significant price declines over the following 12 months. That being said, the timing of a backup in yields is uncertain. If previous mid-cycle slowdowns are any guide, yields might need to wait for a bottom in the global manufacturing PMIs before rising freely. Nonetheless, the current setup argues against adding to long-duration bets. On a PPP basis, the U.S. dollar is only growing more expensive and the U.S. current account is deteriorating anew. For now, weak global manufacturing activity has helped the dollar stay well bid. However, our Composite Technical Indicator has lost momentum and has formed a negative divergence with the Greenback’s level. This means that the dollar is highly vulnerable to any stabilization in growth. In fact, we would argue that the USD might prove to be the best variable to evaluate whether global growth is forming a durable bottom or not. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst Section I, “September 2019,” dated August 29, 2019, available at bca.bcaresearch.com 2 Please see The Bank Credit Analyst Section I, “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 3 Please see U.S. Equity Strategy Weekly Report, “The Oil Factor,” dated September 23, 2019, available at uses.bcaresearch.com 4 J. D. Hamilton, "Historical Oil Shocks," NBER Working Paper No. 16790. 5 Please see Geopolitical Strategy Special Report "Policy Risk, Uncertainty Cloud Oil Price Forecast," dated September 19, 2019, available at gps.bcaresearch.com 6 Please see The Bank Credit Analyst Section I, “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 7 Please see U.S. Equity Strategy Weekly Report, “The Great Rotation,” dated September 16, 2019, available at uses.bcaresearch.com 8 Please see U.S. Equity Strategy Weekly Report, “The Oil Factor,” dated September 23, 2019, available at uses.bcaresearch.com 9 Please see Global Investment Strategy Special Report, “TINA To The Rescue?,” dated August 23, 2019, available at gis.bcaresearch.com 10 Antti Ilmanen, Ronen Israel, Tobias J. Moskowitz, Ashwin Thapar, Franklin Wang, “Factor Premia and Factor Timing: A Century of Evidence,” AQR Working Paper, July 2, 2019. 11 Eugene F. Fama and Kenneth R. French, “Common risk factors in the return on stocks and bonds,” Journal of Financial Economics, 33 (1993). 12 Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, “Fact, Fiction, and Value Investing,” The Journal of Portfolio Management, Vol. 42 No.1, Fall 2015. 13 Ronen Israel and Tobias J. Moskowitz, “The Role of Shorting, Firm Size and Time on Market Anomalies,” Journal of Financial Economics, Vol 108, Issue 2, May 2013 14 Eugene F. Fama and Kenneth R. French, “A Five-Factor Asset Pricing Model,” Working Paper, University of Chicago, September 2014. 15 Fama-French value-growth-size portfolios. 16 Mark P. Cussen, “Value or growth Stocks: Which are Better?” Investopedia, Jun 25, 2019. 17 Please see Global Asset Allocation Special Report titled “Small Cap Outperformance: Fact or Myth?” dated April 7, 2017, available at gaa.bcaresearch.com. 18 Please see Global Asset Allocation Special Report titled, “Is Smart Beta A Useful Tool In Global Asset Allocation?” dated July 8, 2016, available at gaa.bcaresearch.com. 19 Clifford S. Asness, Jacques A Friedman, Robert J. Krail and John M Liew, “Style Timing: Value versus Growth,” The Journal of Portfolio Management, Spring 2000. 20 Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - March 2016,” dated March 31, 2016, and available at gaa. bcaresearch.com. 21 Please see Global Asset Allocation Quarterly Portfolio Outlook, “Quarterly - April 2019,” dated April 1, 2019 available at gaa.bcaresearch.com.
A big driver for retail sales in the U.K. are tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors. The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household…